If Facebook Falls on Its Face

It is way too early to tell whether Facebook shares will end up being a good buy, but the reaction to the initial public offering (IPO) on the first day of trading should serve as a serious warning. While the website may have hundreds of millions of users worldwide, it is not clear that this will translate into profits for the company. Facebook could follow in the footsteps of Pets.com, Webvan and other end-of-the-century start-ups that quickly collapsed following multi-billion dollar IPOs.

Of course Facebook is unlikely to go out of business, but it is certainly possible that its business model is not sufficiently robust to justify a position among corporate America’s elite in market capitalization. A year or two down the road it may well turn out that its share price ends up at half or less of its IPO price.

In this case there will have been an enormous transfer of wealth from the purchasers of Facebook stock to those able to cash out following the IPO. This will make many of those on the inside of the company fantastically wealthy. However, much of their wealth would not result from making a good product that society valued; rather it came from being part of a successfully hyped company.

These insiders benefitted from the ability of Mark Zuckerberg and his colleagues to convince investors that Facebook had much more profit potential than in fact was true. This ability to hype a product, in this case company stock, can be an incredibly valuable skill, but it provides nothing of value to society. In that way it is similar to the skills of Fabrice Tourre (a.k.a. "Fabulous Fab"), who was apparently very skilled in putting together complex mortgage derivatives for Goldman Sachs that were designed to fail.

In the last two decades the economy seems to have created many openings for people whose primary skill is lifting money out of other people’s pockets, not in doing anything productive. Wall Street is the center of such practices.

Many of the country’s biggest earners run hedge funds that specialize in computer algorithms that allow them to front-run large trades. This means that if a major investor is about to buy a large amount of a company’s stock, these high-speed traders can buy shares ahead of them and then resell the shares second later for a profit.

In effect, this is a form of insider trading. It is very profitable for those who can do it successfully, but it provides no benefit to society. It actually harms society and the economy since it reduces the return to honest investors, making them less willing to put their money in the stock market. Wall Street has many other tricks, most notably being able to rely on the no-cost government insurance provided by the implicit too-big-to-fail guarantee.

But today’s story is not Wall Street, or at least not directly Wall Street, today’s story is over-hyped technology companies. Even if Facebook ends up losing much of its value in the years ahead, it is virtually certain that Mark Zuckerberg and other inside players will remain incredibly wealthy individuals. After all, Steve Case is still one of the country’s richest people even though his former company, AOL, could be purchased for pocket change today.

The wealth that these people command was not created out of thin air. It came from suckers who bought the hype. With Steve Case, the big suckers were the top management at Time-Warner. They effectively sold the largest media company in the world for almost nothing, giving away most of the company’s shares in exchange for AOL stock. Shareholders who took the deal and did not immediately dump their AOL shares lost more than half of the value of their holdings.

If Facebook shares plunge we don’t know yet who the big losers will be. Insofar as it is individual investors who knowingly took risks in the hope that Facebook will look more like Google than Webvan, the loss is part of the game. This is like buying a lottery ticket.

But if the list of losers ends up including pension funds, university endowments and other institutional investors, then the public should ask some serious questions of the people who manage these funds. Typically they get paychecks that are many hundreds of thousands or even millions of dollars a year. They should know better than to be suckered by an over-hyped startup.

It will be a while yet before we can tally up the winners and losers. But if Facebook turns out to be mostly a media darling and not a hugely profitable company then the genius of Zuckerberg and crew will be in running a successful scam, not creating anything of great value to society.

Of course it may turn out that Facebook is actually worth its market value in which case none of this discussion is relevant. We will have to wait to know for sure, but until then, don’t believe the hype.

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.